The fund derivatives business has come under pressure in recent years, with post-crisis reforms such as the leverage ratio coupled with a difficult few years for hedge fund managers pushing many banks to exit the once-lucrative business. For those with the staying power to remain, however, there are exciting opportunities to explore – perhaps few more so than the growing demand from investors in mainland China for access to alternatives domiciled offshore.
Credit Suisse, which remains the largest provider of financing to fund of hedge fund (FOHF) managers in Asia-Pacific, has positioned itself well for this bounty, and is already reaping the rewards.
"Over the past few years, most growth in fund-linked products in Apac has come from the institutional client space. But over the past 18 months, we've seen a pretty strong migration toward the retail market – particularly Chinese wealth management. That's dictated by a mixture factors: principally local rate dynamics and restrictions around access to foreign underlyings," says Fayez El Hicheri, head of fund-linked products for Asia-Pacific at Credit Suisse in Hong Kong.
Though firm numbers are understandably hard to come by, the bank estimates the size of the market for mainland wealth seeking access to offshore alternatives via over-the-counter wrappers at 8 billion yuan ($1.2 billion), of which it believes its own share to be roughly a fifth.
Over the past 18 months, we've seen a pretty strong migration toward the retail market – particularly Chinese wealth management
Fayez El Hicheri, Credit Suisse
"We've seen strong interest from Chinese banks in issuing onshore renminbi structured deposits linked to the performance of offshore mutual funds, which are then hedged in the OTC market. The demand was focused initially on Ucits hedge fund-light funds, but as onshore rates have dropped we've seen recently more interest in balanced strategies and fixed-income funds," says El Hicheri.
The hedge, typically a one-year European-style option quantoed into renminbi, is executed with a local bank in an OTC format, says Hicheri. Although the execution format is relatively vanilla, applying it in this context is fairly new, at least post-crisis, he adds.
Fund financing remains a staple business for the firm. Within the Asia-Pacific region, it continues to dominate provision of financing to regional FOHF managers – a business many have withdrawn from due to capital pressures.
In what it hopes is a sign of things to come, the bank confirms it is in discussions with a handful of Chinese asset managers with regards to setting up onshore FOHF businesses – marrying its twin strengths in fund financing with solid access to China.
"We're the largest provider amongst investment banks of financing to Apac-based FOHFs; very few banks still support that business in the region. Given the scale of that industry in Apac, we have quite a large book of trades. We see irregular competition from other houses but no one does it consistently. Our clients do appreciate our commitment to this business, our competitive pricing and the quality of service," says El Hicheri.
Though there are synergies it is able to harness, the bank's fund financing business is not dependent on its prime brokerage arm, which, along with other lenders, has come under pressure following the imposition of the leverage ratio.
The typical legal arrangement for a secured financing loan with a local manager would be for the bank to take a form of a security interest over a manager's hedge fund assets, says El Hicheri, held with a third-party custodian and supplemented by an account control agreement.
The financing is generated by the fund issuing variable funding notes, which are bought by Credit Suisse. The borrower can calibrate its required borrowing amount by issuing additional variable funding notes up to a maximum loan commitment and contractual loan-to-value ratio, or by buying back some notes if the fund needs to reduce its leverage. From a capital and credit standpoint, these are treated as securities financing trades by the bank. Risk management is largely handled from London.